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RBI Thinks India Is Decoupled Amid The Global Storm. Is It?

As the post-pandemic bounties recede, India’s GDP growth is expected to slow to 5.0-5.5% in FY23, lower than RBI’s estimate of 7%.

<div class="paragraphs"><p>The RBI building. (Source: BQ Prime)</p></div>
The RBI building. (Source: BQ Prime)

The RBI’s guidance of a decoupled India is untenable. The central bank has considered the latest global shock in the form of dollar strengthening and rate tightening as a storm and the reason for scaling down of real GDP growth projection for FY23E to 7.0% from 7.2% earlier. But implicit in this projection is an upscaling of growth expectation for Q2 FY23–Q4 FY23. It is projected to average 5.2%, higher than 4.9% forecasted in August 2022. 

The RBI’s guidance is an assumption of a decoupled India which considers that “while it is a soft-landing for advanced economies, it will be a takeoff for India” even as it faces a stormy global shock. This is optimistic as India’s growth sensitivity to global trade volume growth has risen to 1.73x over the past 10 years from 1.14x in 2008. 

The stimulus-led demand wave in advanced economies resulted in a significant surge in global export volume growth (5.1%, 2019-21 CAGR), particularly for China (25%) and India (11%). Thus, with India's real GDP growth averaging at just 2.3% (2019-21, CAGR), it is apparent that the five-times higher exports surge along with global spillovers, like recovery in commodity prices and surplus dollar liquidity, contributed significantly to India’s post-pandemic recovery.

Sectors like metals, textiles, readymade garments, chemicals, machinery, auto parts, gained from higher commodity prices, rising order book, booming cash flows, and a rise in market capitalisation.

The synchronous global monetary tightening, particularly the U.S. and Europe, is now creating negative externalities, resulting in OECD scaling down global growth projection to 3% in 2022 from 5.8% in 2021, followed by further moderation to 2.2% in 2024.

Thus, as the post-pandemic global bounties recede, India is bound to experience a significant impact. We expect India’s GDP growth to slow to 5.0-5.5% in FY23, much lower than the RBI’s projection of 7%, and aligning with the structural trajectory at 4-4.5%.

Additionally, post-pandemic improvement in India’s employment has been concentrated in sectors dependent on global impulses, particularly machinery, and chemicals. Similarly, in service sectors, it has been in wholesale and retail trades, BFSI, and IT sectors, which have strong global linkages. Thus, global tightening will influence corporate decisions on investments and deployment of labor. As a precursor, India’s non-oil exports have contracted 24% from the March 22 peak.

What Will Be India’s Terminal Rate?

The question of the terminal policy rate in the current tightening cycle is critical as:

  • The RBI expects inflation to average at 6.7% in FY23, higher than its target of 4%, and;

  • The U.S. Fed rate is projected to rise to 4.6% in the ongoing tightening cycle. 

Here, the paradox is a twin. 

First, the RBI continues to remain accommodative stance within its “reduced accommodation” stance instead of tightening. At 5.9% the real repo rate is still negative (-1.1%) and as per the RBI banking sector liquidity is in excess (LAF balance adjusted for government surplus with the RBI). Implicitly, the RBI considers high inflation to be transitory, not requiring tightening. 

Second, the view that the RBI’s rate decision is entirely dependent on domestic price stability goals needs to be contested against the backdrop of the Fed’s restrictive tightening.  

India’s trade deficit/GDP rising to 8.2% in Q1 FY23 and current account deficit/GDP at 2.8% despite a structurally low real GDP growth, is symptomatic of a declining savings rate. Incremental household financial assets/GDP declined to 10.8% in FY22 from the episodic rise to 16% in FY21. Net household savings may have declined further in 2022 due to low real interest rates and rising personal loans, growing at 18% for banks. 

Hence, as U.S. rates tighten resulting in moderating capital flows, FDI, FII, ECBs, and NRI deposits, together contributed just 1% of GDP (Q2 FY22–Q1 FY23), there can be a structural shortfall of external flows in meeting India’s external deficits. While there was an abnormal $19-billion net inflow of external assets under banking capital in Q1 FY23 (BoP data, 2% of GDP) which compensates for the moderating major capital account items, such sporadic adjustments are not enduring.

Hence, raising real interest rates in India to levels that can encourage savings may become imperative.

For India, the real repo rate is currently at -1.1% vs a pre-Covid average of 2.3%. Thus, if we assume CPI inflation softens gradually to 5% in 2023, the plausible repo rate target could be 7.25-7.5%.

Considering the pre-Covid average India-U.S. real rate differential at 2.5% (2014-19) and assuming a 1.0% real rate for the U.S. (as per FOMC's latest projections it is placed at 1.6% by end of 2024), India’s real rate should be at 3.5%. And with an inflation of 5.0%, the nominal policy rate works out to be higher than 8%.

Since the U.S. Fed rate lift-off, the RBI has maintained 300-basis-point spread between the U.S. Fed rate and India’s effective rate short-term money market rate rising, currently at 6.1% now. Thus, if the terminal level of the U.S. Fed rate is 4.6%, India’s repo rate could rise to 7.5%. Considering these scenarios, a plausible terminal rate for India appears in the range of 7.0-7.5%.

The Forex Adequacy Gap Is Widening

The RBI’s response to forex reserve adequacy concerns was twofold:

  • Notwithstanding the $105-billion decline of forex reserves to $537 billion, the buffer is strong, and;

  • The RBI insists that the rundown of forex reserves was not due to currency interventions. 

It implies that the relative outperformance of INR/USD (down 10% in 2022) against the major currencies (EUR/USD and GBP/USD down 14% and 17% respectively) is due to stronger growth performance. 

However, our estimation indicates both China and India scaled up the degree of inflexibility in response to a stronger dollar, implying that the rundown of forex reserves by India and China has been also due to interventions. There has been a strong co-movement between independent currency pairs such as INR/GBP and USD/GBP (rolling correlation of three-month returns rose to 0.96 in 20 weeks window). 

But this inflexibility could get less sustainable as forex buffers dwindle further (currently at seven months of imports). Our estimate of optimal forex reserves based on our buffer stock model is placed at $740 billion, which implies that the RBI’s forex reserves at $537 billion are 27% lower.

Overall, we think that the RBI’s guidance on most fronts is going to see significant calibrations as it starts to factor in the global headwinds. Following the earlier unsuccessful attempt to garner NRI deposits by allowing banks to offer higher rates, it is likely that RBI will take more forceful measures to plug the savings gap, shore up the forex buffer and allow further depreciation in the Indian rupee.

Dhananjay Sinha is director and head – research, strategy and economics at Systematix Group.

The views expressed here are those of the author, and do not necessarily represent the views of BQ Prime or its editorial team.